The carry trade strategy involves hedge funds borrowing low-interest-rate currencies, such as the Japanese yen, to invest in high-yield assets globally. This strategy has gained traction in recent years, especially with investors betting on the Japanese yen remaining weak and interest rates in Japan staying low.
However, carry trade investors using the yen started to unwind these positions en masse last week when the Bank of Japan (BOJ) unexpectedly raised interest rates for the second time this year on July 31st, causing the yen to strengthen significantly. This triggered a massive sell-off in global financial markets.
According to Richard Kelly, TD Securities’ global strategy head, it is “difficult” to declare that the wave of outflows from carry trades has ended, even though some economists suggest that the reduction in carry trade positions is almost complete.
“I disagree with that view. We don’t have actual data on carry trade transactions. I believe there is still a lot of room for further outflows, especially considering the yen’s current valuation,” said Kelly.
There are no official figures on the amount of money poured into carry trades. According to data from GlobalData TS Lombard, approximately $1.1 trillion has been invested in this type of transaction, assuming that all the money borrowed by foreign investors from Japan since the end of 2022 was used for carry trades and that Japanese investors also used financial leverage to purchase foreign assets.
Barclays analysts shared Kelly’s view from TD Securities, stating that the pressure to exit carry trades remains, and it is “too early” to say that the wave of outflows from these transactions has passed.
“Investors are likely to remain highly cautious in the coming weeks, and liquidity is still fragile. We forecast that volatility will remain high and continue to impact carry trades,” said Barclays analysts in a research report published Sunday.
“Last week’s large-scale and dramatic sell-off was actually good news because it forced investors to focus on the real Japan strategy. The real Japan strategy is not about short-term carry trades but about benefiting from corporate restructuring and sustainable wage growth.”
Jesper Koll, Director at Monex Group
“If you look at the current patterns and market sentiment, many might think that now is the time to get back into carry trades, buy Mexico and Brazil stocks, and other high-yield assets, and start shorting the yen,” Kelly said. “But I don’t think that’s the case; there has been a structural change. The BOJ will continue to tighten, the yen is fundamentally undervalued, and the Fed is about to start easing. All these factors will change the direction of interest rate differential trades.”
Kelly mentioned that he would not return to buying high-yield assets in emerging markets but would instead buy the yen.
Kelly’s recommendations come as the latest economic data paints a brighter picture of the US economy. The Producer Price Index (PPI), a measure of wholesale prices, rose 0.1% in July from the previous month. This increase was lower than the 0.2% forecast by economists in a Dow Jones poll and matched the 0.1% rise in June.
The PPI data boosts investors’ confidence in the continued decline of inflation in the US economy. The market expects the Consumer Price Index (CPI) that the US Department of Labor is expected to release on Wednesday to show a 0.2% increase in July from June, after the index unexpectedly fell 0.1% in June.
All these factors could help the Fed gain more confidence in starting to cut interest rates as early as next month. Last week’s massive and swift sell-off of risky assets also stemmed from fears that US economic data would fall short of expectations.
“Last week’s large-scale and dramatic sell-off was actually good news because it forced investors to focus on the real Japan strategy,” said Jesper Koll, director at Monex Group, to CNBC. “The real Japan strategy is not about borrowing money at near-zero interest rates in Japan to invest in high-yield assets. The real Japan investment strategy is to benefit from corporate restructuring and sustainable wage growth—which is happening in the country. So, focus on the real economy, not the bubble economy.”
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